What is Arbitrage?
Arbitrage means buying an asset where it is cheaper and simultaneously selling the same asset, or an equivalent position, where it is more expensive, locking in the price difference. In stocks, that can mean a share listed on two exchanges trading at slightly different prices; in options, it means exploiting a break in put-call parity, where stock + put should equal call + the present value of the strike. These gaps are small, often last seconds, and are mostly captured by firms with automated trading systems, so costs and execution speed decide whether an opportunity is real.
The Arbitrage strategy is common in blockchain trading and the foreign exchange market.
It exploits the opportunity of earning profits through variations in prices in different markets. This strategy also exploits the market’s inefficiencies and pricing errors. Arbitrage opportunities are available for a very short period. They last for only a few seconds sometimes.
There are various complicated and straightforward scenarios of arbitrage trading.
Let us see how we can profit from arbitrage stocks and arbitrage options strategies.
Profit from Arbitrage Stocks
Let us understand a simple scenario of arbitrage trading.
Consider a stock listed on two exchanges, trading at the equivalent of $12.40 on one and $12.44 on the other at the same moment.
An arbitrage trader can buy on the cheaper exchange and simultaneously sell on the more expensive one before the prices converge. These transactions happen in seconds. Hence, the arbitrage traders need fast, automated trading systems to complete both trades before the price gap closes.
Arbitrage profits per trade are small, and the strategy still carries execution risk. The risk is that these trades are difficult to track and execute by average day traders. Hence, traders who do not have systems installed that facilitate arbitrage trading should not try their hand at it. They might lose a lot of money if they fail to execute the sell order on time, and the price in both the exchanges falls below the purchase price.
Another risk is that there are possibilities that arbitrage trades are on leverage, which would reduce the money in hand after the execution leverage.
Other risks associated with arbitrage trading are:
• Opportunity risk – With the passage of time, the profits decreases, and the opportunity risk increases due to rising competition
• Liquidity risk – What if you are not able to sell the asset due to low demand
• Cost of transaction – For the entire process, you will need to pay specific transaction fees. The cost of a transaction is an essential factor that might make or break an arbitrage opportunity.
• While selling the same stock at BSE/ any other exchange, you might need to consider foreign exchange rates as well.
Profit from Arbitrage Options
The Options Arbitrage Strategy is
Put-Call Parity
The put-call parity is a relation as per which the investor gets the same payoff from:
1. Buying a put and buying the underlying stock
2. Buying a call and buying a risk-free, zero-coupon bond
This can be given as:
Price of underlying stock + Price of put = Price of call + Present value of exercise price
Cost of the first strategy = Cost of the second strategy
In other words, a call plus a bond paying the strike at expiration must cost the same as the stock plus a put with the same strike and expiration; if not, buying the cheaper side and selling the richer side locks in the difference. The transactions of the options arbitrage are executed in the same market.
The conditions for this are:
• Put and call both have the same expiration date and the same exercise price
• The maturity date of the zero-coupon bond must be the same as the expiration date of the options
An arbitrage opportunity occurs if there is a deviation between the value of calls and puts with the same strike price.
Put-Call Parity in MarketXLS
MarketXLS provides a ready-to-use template for working on Put-Call Parity Strategy.
Put and call prices are related through put-call parity, which specifies that the put price plus the price of the underlying equals the call price plus the present value of the strike price. Further, for making profits using arbitrage, the software also helps you to find out whether the arbitrage opportunity exists or not.
Let us have a look at the template:
‘Active Template’ Sheet
The template automatically does all the calculations and analysis.
Here, you have to enter the following information:
• Mention Stock ticker in cell ‘C13’.
• Enter the Expiry date of the option in cell ‘C18’. A table of upcoming expiry dates has been provided beside the input.
In the above example, you can see that, according to the template analysis, Arbitrage Opportunity Exists for the option of the stock ‘MSFT.’
This is because put-call parity does not hold, and there is a deviation in the price.
The software also provides the payoff profile of the option by classifying it into two portfolios.
Here, you have to enter the maximum and minimum value of the share price for the chart.
The template itself does all the other calculations based on the expiry price.
The resulting two portfolios are shown in a chart format.
The Bottom Line
Arbitrage trading enhances and improves the efficiency of capital markets. As mentioned earlier, arbitrage trading carries risk alongside profits. New traders should be careful while using the strategy of arbitrage trading in stocks as well as options.
Arbitrage trading opportunities are of a very short span. Algorithm-based trading software tracks them.
For more articles on stock market strategies, visit the MarketXLS blog.
Disclaimer
None of the content published on marketxls.com constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person.
The author is not offering any professional advice of any kind. The reader should consult a professional financial advisor to determine their suitability for any strategies discussed herein.
The article is written to help users collect the required information from various sources deemed to be an authority in their content. The trademarks, if any, are the property of their owners, and no representations are made. All trademarks referenced are the property of their respective owners. Other trademarks and trade names may be used in this document to refer to either the entity claiming the marks and names or their products. MarketXLS disclaims any proprietary interest in trademarks and trade names other than its own or affiliation with the trademark owner.
